Digital Transformation in Real Estate has led to the emergence of new age Property Technology (PropTech) platforms which leverage innovative technology to create new age investment avenues in Commercial Real Estate. These PropTech platforms are enabling investors gain access to high value high return investment opportunities in commercial real estate through a mode of investment called Fractional Ownership.
Prior to the emergence of PropTech, investment opportunities in Commercial Real Estate (CRE) were accessible only by institutional and high net worth investors who had specialised knowledge of the sector and access to sizable capital to invest. Investing in Commercial Real Estate was not feasible for the average retail investor owing to large ticket sizes, illiquidity in long term investments, and a lack of understanding of the commercial property market.
Investing in land and residential property has traditionally been the preferred choice of investment for retail investors. Despite its popularity, managing investments in land and residential property often pose significant constraints to the investor. Investing in physical real estate (i.e., land or residential property) not only requires a sizable investment corpus but also requires sizable expenditure for settling maintenance costs, property tax, interest on home loans and other expenses associated with owning a property. These financial constraints in owning and managing physical real estate can prove burdensome to the investor and can remove the lustre of their investment. As a solution to these constraints, fractional ownership offered by PropTech platforms provide a lucrative and liquid investment alternative to invest in managed commercial real estate.
What is Fractional Ownership in Commercial Real Estate?
Fractional Ownership offered by PropTech platforms is a concept wherein several investors can collectively invest in a tenanted pre-leased commercial property and become its fractional owners.
Investment through fractional ownership reduces the financial burden of a single investor as it divides the total purchase cost of the property into multiple fractions. A commercial property leased to a premium tenant can cost a single investor Rs.40 crores and above to purchase. However, through fractional ownership the investor can purchase and own a fractional share of the property for a minimum investment of Rs. 25 lakhs. Thus, with smaller ticket sizes, retail investors have the flexibility of gaining exposure to multiple sectors in real estate such as Office Space, Warehousing facilities, etc and diversify their investments in real estate.
Through fractional ownership, investors can earn a steady stream of rental income paid for by tenants residing in the property, have the option of liquidating their investment by selling their fraction of ownership and benefit from capital appreciation in property value. The income received from the underlying asset will be proportional to the investor’s investment.
How Do Investments in Fractional Ownership Work?
For every commercial property listed on a Proptech platform, a private company called a Special Purpose Vehicle (SPV) is created for the sole purpose of managing investments for purchase and upkeep of the property.
Investors receive a proportional allocation of equity shares and compulsorily convertible debentures from the SPV under whose name the property gets registered. 5-10% of the invested capital is treated as unlisted equity shares, making the investor a fractional shareholder of the SPV and a fractional owner of the pre-leased property. The remaining 90-95% of the invested capital is treated as a Compulsorily Convertible Debenture wherein the investor receives monthly interest payments for his share of investment.
The interest rate on the debenture is dependent on rent paid by the tenant and interest earned on security deposit. Rental income and interest on security deposit will vary for each asset. Typically, rental yields for premium commercial properties yield 8-10% annually with rental escalation taking place year on year or every 3 years.
The Investment process in physical real estate involves copious amounts of paperwork and can be a time-consuming affair. However, with investments through fractional ownership, PropTech platforms facilitate and manage all aspects from leasing, reporting, due diligence, and tenancy. All key property documents such as rental agreements, title reports and due diligence can be readily accessed through the dashboards of the respective platforms. This enables investors to make seamless and hassle-free investments in commercial real estate.
Liquidity and Lock-in Period for Investments in Fractional Ownership
Upon investing in fractional ownership, an investor’s capital may be locked in for a minimum of 6 months to a year from the time the property gets registered with the SPV. During this period, investors are not allowed to sell their fraction of shares to a third party. Post the lock-in period, investors are eligible to sell their fraction to fellow investors registered on the platform or can sell it to interested third-party investors subject to KYC guidelines.
Though investors have the option to exit early, an early exit could adversely affect their return on investment as it typically takes 4-5 years for the property value to appreciate. Therefore, fractional ownership is ideal for investors with an investment horizon spanning 5 years and above.
If a lucrative opportunity to sell the property arises, the PropTech platform managing the property will evaluate the exit opportunity and present investors an opportunity to vote on whether they would like to hold or liquidate the asset. A decision is reached on the outcome of the voting process.
Taxation of Your Fractional Ownership Investment
Investment Opportunities in Fractional Ownership are open to both residents and NRIs. As per current regulations, resident and NRI investors will be taxed on their monthly rental income and on capital gains arising from the sale of their fractional ownership units.
Rental Income: Rental income earned from the property will be taxable at the hands of the investor as per his/her slab rate under “Income from Other Sources”. For resident Indians A Withholding Tax Rate (TDS) of 10% will be deducted from the monthly rental income by the PropTech platform whilst for NRIs, a TDS of 30% (including cess and applicable surcharge) will be deducted. NRIs have the option of availing benefits under the Double Tax Treaty Avoidance Agreement that India may have with their respective country of residence (subject to the availability of a Tax Residency Certificate).
Capital Gains: The profit earned from the sale of the asset will be taxed either as Short-Term Capital Gains Tax or as Long-Term Capital Gains Tax subject to the following conditions:
- Short Term Capital Gains: Gains on sale of assets will be taxed as per normal income if sold in less than 3 years.
- Long Term Capital Gains: Gains on sale of assets will be taxed at 20% with indexation benefits if sold after 3 years.
Evaluating Your Fractional Ownership Investment
With investment opportunities in fractional ownership gaining traction, a prudent evaluation process is necessary to choose the right asset to invest in.
As investors, we can evaluate the attractiveness of a commercial asset based on the following parameters:
1. Economic Outlook (Demand & Supply)
Commercial Real Estate comprises of various sub-sectors such as Office Space, Retail, Warehousing/ Manufacturing, data centres etc. The impact of prevailing market conditions, economic policies and market outlook will differ for each sub-sector. Thus, market demand and supply will consequently vary for each sub-sector.
When assessing a property, investors must identify the sub-sector the property comes under (Is it an Office Space, Warehousing facility, manufacturing plant etc..) and assess if there are favourable economic policies in place (government subsidies, lower taxes, etc.) to drive demand in that sub-sector.
An assessment of demand and supply for sectors in real estate is published by JLL, Knight Frank and Cushman on a regular basis. If supply were to exceed demand, it could subsequently bring down rental rates and property prices for both old and new buildings in that sub-sector. New buildings would command lower rents as tenants will have more options in the market whilst tenants in older buildings may renegotiate rents and their escalation clauses. This could adversely impact the generation of rental income and capital appreciation.
2. Asset Location
Location is a key factor to consider as it plays an important role in determining rent and capital appreciation of the underlying asset. When considering the location of the underlying asset, it is imperative to not only assess the quality of the existing infrastructure but also to take note of any major government or commercial plans in place to further enhance infrastructure in the surrounding area.
Upcoming developments in the area could include the building of public transport facilities (metros, bus stops, airport), roads etc. Major developments that positively influence the attractiveness of the area can serve as a key factor in driving capital appreciation of the underlying asset.
3. Asset Quality (Grade A, B, B+)
Properties are given an alphabetical rating on their quality based on a multitude of factors ranging from age, amenities, quality of maintenance, and growth prospects. Properties rated Grade A+ and Grade A are of the highest quality and often attract premium tenants. Investing in a Grade A or Grade A+ asset can benefit the investor by generating higher rental yields (8-10%), tenant retention and higher capital appreciation. Properties with certifications like LEED Gold/Platinum are cost-efficient, thus maintenance costs charged to investors will be significantly lesser enabling them to benefit from a higher net rental income. A quick resale of such high-quality properties is likely.
4. Tenant Quality
In addition to considering the quality of the property, one must equally consider the quality of the tenant when evaluating an investment in commercial property. A high-quality tenant pays rent on time, pays higher security deposits and is less likely to vacate the premises. Therefore, opting for commercial properties with blue-chip tenants would be ideal for investors as they not only provide stability but also elevate the commercial value of the property. Small and medium-sized companies on the other hand pose a higher tenancy risk as they run the risk of facing cash flow issues and usually opt for shorter lock-in periods.
5. Security Deposit
In commercial properties, a quality tenant usually settles the security deposit for 10-12 months. However, if a tenant settles the security deposit for less than 6 months, it could mean they are either facing cash flow issues or are looking for a shorter tenancy period. Usually, small to medium-sized tenants pay smaller deposits and negotiate for shorter lock-in periods, making them riskier tenants.
6. Stickiness of the Tenant
When evaluating a tenant, investors must consider the following criteria to verify if vacancy risk posed by the tenant is mitigated:
- Tenant Lock-in: Tenants with Lock-in periods for 5 years and more are an ideal choice. This ensures that the tenant is not allowed to vacate the premises till the end of the lock-in period.
- Vacancy Rate: The vacancy rate of the underlying asset and the surrounding location is critical to consider. Locations with a single-digit vacancy rate are ideal as it implies that supply in the area is stable and tenants residing in the area are less likely to vacate. This reassures investors of the stickiness of tenants.
- Interior Fit-outs: Investors must enquire if interior fit-outs in the property are done by the developer or the tenant. In India, new properties delivered are bare shells (resemble an empty garage). The tenant is responsible for the interior fit-outs and furnishing of the property (flooring, wiring, installing air conditioners, rooms etc..). Tenants can do their own fit-outs or can have developers do it on their behalf. Developers who do the fit-outs usually charge an additional fit-out rent of Rs.25- 30 per sf monthly for a fixed period. Ideally, tenants who do their own fit-outs are less likely to vacate and more likely to reside in the property for longer periods to recover the sizable fit-out CAPEX they have invested in the property.
- Market Rent vs Contractual Rent: This is a concept used by experienced investors to assess the likelihood of a tenant negotiating their rent or vacating the premises at the time of renewal.
Market rents are governed by demand & supply dynamics and can escalate faster on an annual basis. Contractual rents on the other are paid by tenant as per their tenancy contract and will escalate as per terms agreed in the contract. For example, market rents can escalate 10% Year on Year whilst contractual rents may escalate by only 5% year on year. Ideally, investors should look for tenants who are paying lower contractual rents than market rents as they are less likely to vacate the premises as they must pay higher rents in the market.
7. Purchase Price and Rentals
When assessing a property, as prudent investors it is imperative for us to ensure that the property’s purchase price and rentals are fairly valued as per market conditions. Therefore, we must compare its purchase price and rentals with similar properties in the market. A comparison with market rates will enable us to understand if the underlying property is overvalued or undervalued. Investing in overvalued properties can prove detrimental, as future buyers may forgo your property making it difficult to achieve a profitable exit. In case of significantly undervalued properties, one must investigate thoroughly the rationale behind undervaluation of the asset. There is a possibility that the asset may be of lower quality, have high vacancy rates or could have unstable tenants facing cash flow issues.
8. Due Diligence
Due Diligence constitutes a crucial component in property selection. Before committing to invest in a property, investors must verify if the PropTech platform has engaged with a Tier 1 law firm to perform thorough technical and due diligence on the property before listing it. Investors must check that a clear property title is provided. This confirms that the property belongs to the seller and no third party has a claim over it. Investors must confirm if the property has met all necessary clearances and approvals from various departments and the respective Occupancy Certificate and No Objection Certificate are issued for the property. This confirms that the building is compliant with all regulatory measures in place. With the property being tenanted, investors must verify if all terms in the lease deed are in line with what was agreed with the seller. All the necessary legal documents should be provided by the PropTech platform.
Fractional Ownership has rebranded the mode of investment and ownership in commercial real estate. It has provided a lucrative and affordable avenue for retail investors to gain exposure in commercial real estate. While we can evaluate the attractiveness of an asset based on the above parameters, the likelihood of a successful exit from the asset is dependent on the credibility and management capabilities of the founders managing the PropTech platform.
A high-quality asset can generate an IRR of 12-15% in 5-8 years. However, it is subject to liquidity risk, default risk and potential loss of capital. These risks can also be largely mitigated based on the experience and management capabilities of the founders and their team. Nevertheless, investors must comprehensively evaluate the risks and take financial and legal advice before investing in fractional ownership opportunities.